Life insurance companies, through the issuance of life insurance policies, accept a transfer of the risk of adverse financial consequences which would be created when an insured life dies. Typically, the death of an individual creates adverse financial consequences for those who depend on future income or work contributions lost as a result of the individual's death. A life insurance policy is typically purchased to provide a beneficiary with a death benefit payment. The purpose of the death benefit payment is to provide the beneficiary with the means to offset, at least in part, the financial strain created by the unexpected or untimely early death of the insured.
Life insurance pricing (that is, the determination of the premium charged by the insurance company for the acceptance of a stated death benefit risk) is based on a number of factors for which assumptions are made including: mortality, interest, expenses (including taxes), and policy persistency. Policy persistency is the probability that the owner of a life insurance policy will choose to keep the policy in force by paying the premiums required as per the terms of the insurance contract. A policyholder who does not persist is said to have lapsed. An assumption with respect to lapse rates is typically the way persistency is incorporated into pricing calculations. Pricing assumptions are made prior to the issuance of a life insurance policy and are made relative to an entire class of insured lives and not with respect to individual insureds.
A number of different sets of pricing assumptions may be used. Assumption sets may vary by mortality class, type of distribution used, or by other characteristics commonly used to distinguish between classes of insured lives in the insurance industry. For example, different mortality assumptions may be applied to males versus females or to non-smokers versus smokers. Those skilled in the art are well aware of the fact that many other mortality class distinctions exist or are possible.
Also, different expense assumptions may be applied in different marketing situations. For example, insurance offered directly to the consumer in a direct marketing distribution channel versus insurance offered through a traditional agent based distribution channel will have different expense assumptions applied to reflect the different expected costs in these different marketing channels.
The interest rate assumptions used in pricing are important because they provide an adjustment for the timing differences between when cash goes into and out of the pricing calculations.
Persistency or lapse assumptions affect pricing calculations by creating an expectation with respect to the occurrence of cash flows which are dependent on the insurance policy being in force or effect.
When an individual insured applies for life insurance, an underwriting process is applied. The underwriting process determines, the appropriate premium or underwriting class for the applicant based on an evaluation of the applicant's mortality characteristics and life expectancy. This is based in part on expertise the underwriter derived from prior training or experience. Life expectancy is the average number of years individuals in the same underwriting class can be expected to live. Maximum life expectancy is the highest age to which an individual in the underwriting class can be expected to live.
A life insurance policy may provide for some change in assumptions after the policy is issued. Such changes would modify the current charges or credits provided for in the policy for a class of insureds. These changes would result in a change in the overall cost of the life insurance for each insured in the same class of insureds. Such changes can only be justified by changes in experience after issue for the whole class to which an insured belongs and can only be applied to all insurance policies in the class. Typically the range of change allowed in a life insurance policy is limited by minimum or maximum guarantees made in the life insurance contract or policy relative to each assumption that may be changed.
One type of life insurance policy contains an endowment feature. This type of life insurance policy is called an endowment policy. With respect to such life insurance, the insurance company would pay an amount called the endowment benefit to the insured on the endowment date, for example age 65, if the insured survived to that date. Because of changes in the way life insurance is taxed by the US federal government, endowment policies of this sort are, typically, no longer offered as there are adverse tax consequences associated with life insurance policies that endow prior to age 95.
The assumptions used in pricing a life insurance policy include an assumption regarding the maximum life expectancy of the lives insured. For many currently issued life insurance policies, this maximum life expectancy has been assumed to be age 100. More recent mortality tables used for life insurance pricing purposes are beginning to recognize longer maximum life expectancies, for example, age 120. These longer maximum life expectancies are made possible by improvements in health care and a general improvement in the health of the insured life population. Mortality tables developed for purposes other than life insurance pricing may have found it convenient to make assumptions regarding the maximum life expectancy different from age 100. For example, annuity products may use mortality tables for pricing purposes with a maximum life expectancy greater than age 100.
This maximum life expectancy age is often referred to as the maturity age for the life insurance policy. Any insured who survives to the end of this period can be thought of as reaching the ultimate endowment age. Typically, life insurance companies will make the death benefit of the life insurance policy available in some way to insureds who survive to the maturity age. One alternative is to pay an amount equal to the death benefit at the maturity age directly to the insured as an endowment benefit on the maturity date. Another alternative is for the insurance company to hold such a maturity age endowment benefit in an interest bearing account until such time as the insured actually dies. Then the benefit is paid as a death benefit. This later alternative is used to potentially avoid the possible adverse tax consequences associated with paying the death benefit to the insured before the insured actually died.
In the past, the value in a life insurance policy was determined only by the contractual terms of the life insurance policy and confined to the relationship the owner of the policy had with the insurance company providing it. Recently, however, secondary markets for life insurance policies have developed in which a life insurance policy is purchased or the right to receive the death benefit is assigned to a third party by the owner of the policy in exchange for a fee or purchase price.
Examples of the operation of secondary markets can be seen in the life settlement market and viaticals. These markets involve life insurance policies on insured lives who become impaired after their policies were originally issued. In these markets, life insurance policies are purchased by third parties (that is, neither the owner of the policy nor the insurance company issuing the policy) or assigned to third parties for a fee or payment of some sort. For such payment the third party receives the right to receive the policy death benefit when the insured dies.
An impaired life is an insured life who develops an impairment after the life insurance policy was originally issued which reduces his or her life expectancy. An impairment is any medical condition affecting the health status of the insured life which results in a higher mortality rate for the insured life than was reflected in the original mortality assumption made for the underwriting class the insured was assigned to when the insurance policy was issued. Because of the impairment acquired after original issuance of the policy, the likelihood of an earlier than expected death claim is increased. This situation may make life insurance policies covering such impaired lives worth more than the cash surrender value provided by the contractual terms of the policies.
The cash surrender value of a life insurance policy is the amount of money the life insurance company that issued the policy is willing to pay if the policy is lapsed or surrendered. A life insurance policy is lapsed if the owner of the policy stops paying the premiums required to keep the policy in force per the terms of the life insurance contract. For a typical term life insurance policy or whole life insurance policy, the policy lapses when the owner stops paying the contractually required premiums. A whole life insurance policy may have a cash value at the time it lapses which can be surrendered and paid to the policy owner in cash or applied by the policy owner under one of the nonforfeiture options contained in the policy contract.
For a universal life or variable universal life insurance policy with a flexible premium structure, the policy lapses when the cash value of the policy becomes insufficient to cover the insurance related charges specified in the policy contract. Typically this occurs because the policy owner has not made premium payments prior to the lapse sufficient to keep the policy cash value large enough to cover said charges.
A life insurance policy can be surrendered by an owner who voluntarily agrees to terminate the life insurance protection provided by the policy in exchange for the payment of the policy's cash surrender value. A life insurance policy's cash surrender value is the cash value of the policy defined in the life insurance contract adjusted for any amounts owed by the owner to the insurance company (for example, policy loans) or any additional amounts owed by the insurance company to the owner (for example, dividends). For universal and variable universal life insurance forms of insurance there may also be specifically stated surrender charges which are deducted to determine the cash surrender value.
Life insurance benefits may also be assigned to third parties in insurance marketing programs in which life insurance is used as a funding mechanism by a benefit plan sponsor. The benefit plan sponsor is a third party which pays for or in some other fashion enables benefits related to the life or health of an individual or individuals. The benefits provided by the benefit plan sponsor consist of cash payments designed to fund health, retirement, or death needs. Funding mechanisms which utilize life insurance benefits rely either on the cash values built up within a set of life insurance policies or the life insurance policies' death benefits to meet funding requirements for a benefit plan.
Several benefit plans have been funded with the expectation of full or partial funding cost recovery via anticipated or expected death benefit proceeds from the life insurance policies. When death benefit proceeds are used to reduce or recover the cost attributable to benefit plans, it is important that the death proceeds be received in a predictable manner based on a set of mortality assumptions chosen by the benefit plan sponsor. Such chosen mortality assumptions, however, are often inaccurate due to the fact that the actual mortality experience for a selected group is difficult to determine because, generally, such data is not publicized by the insurance companies or reinsurance companies that collect the data.
Many benefit plans involving the use of life insurance policies as a funding vehicle do not take into account changes in the health status of the insured lives after the insurance policies were issued. That is, they do not rely for their value on the insured life becoming impaired. In order for life insurance policies to be an effective funding tool in programs in which death proceeds are the funding source, however, the death benefits actually received must be reasonably close to the death benefits expected based on the mortality assumptions used to set up the program.
It is well recognized that for the financial products created by the use of life insurance death proceeds as a funding vehicle, adverse financial consequences are created if the actual mortality experience of the lives insured under the life insurance policies being used is better than assumed. That is, adverse financial consequences are created for the third parties if the insured lives, as a group, live longer than expected. This can occur, for example, if a financial product is created by the purchase of a pool of life insurance policies insuring a group of insureds who have lives that are impaired at the time of purchase but who ultimately as a group live longer than expected. The investors providing the cash used to make these purchases are expecting a return on the money they have invested. The return the investors receive is derived from the death benefits that are paid on the life insurance policies that were purchased with the cash they provided. This return is expected to consist of the return of their invested principal plus an investment return. The amount of the investment return or income the investors receive is dependent on the amount and timing of the actual death benefit proceeds received from the group of policies purchased. A purchase price value is calculated for the policies being purchased which is based on mortality assumptions from which the timing and amount of expected future death proceeds can be projected. In addition, other expense and risk charge assumptions are typically made in order to determine a final purchase price for such life insurance policies.
Since it is the death proceeds of the group of policies purchased which provide the revenue to pay back the investors their principal and a return on their investment, the actual death proceeds must be reasonably close to the expected death proceeds in amount and timing for the expected investment return to be realized. In a life settlement transaction, the investors would experience adverse financial consequences if the insured lives experienced better mortality as a group than the mortality assumption used to determine the purchase price for the policies.
Another example of when a set of insureds living longer than expected would have adverse financial consequences for a third party beneficiary, would be a situation in which a benefit plan's funding was dependent on the actual death proceeds from a life insurance policy or group of life insurance policies for which the insured or insureds health was not impaired. The benefit plan sponsor anticipates receiving life insurance policy benefits in an expected manner with respect to timing and amount. Such expectation would be based on the assumed level of mortality used in establishing the benefit plan's funding. Death benefit proceeds received by the plan sponsor later than expected, in lower amounts, or not at all would result in adverse financial consequences to the benefit plan sponsor since this would result in the benefit plan being under funded.
The financial risk that a third party beneficiary faces from a set of insured lives living longer than expected is referred to herein as a “survival risk”. There is a need for a method of insuring against the adverse financial consequences of survival risk.
Given the variety of benefit programs in the insurance industry which are based on the inherent tax advantages attributable to the payment of death benefit proceeds and rely on the timely payment of death benefit proceeds according to projections based on reasonable mortality assumptions, it would be desirable to have an insurance product under which the risk of survival and the adverse financial consequences of survival longer than expected could be transferred from one entity to another entity willing to accept that survival risk for a premium.